1. The water periodic review currently under
way has raised substantive issues about the nature of the regulatory
regime, as well as the appropriateness of proposed price increases,
and its impact on current and future customers.

2. This memorandum summarises the causes
of the proposed price increases for the period 2005-10, and considers
the consequences of the flight-from-equity which has followed
the 2000 periodic review outcome. A number of recommendations
for the conduct of the current review and the future regulation
of the water industry are made.

3. The last periodic review in 1999-2000
imposed a one-off price reduction on the industry, pruned back
the capital programme on the basis of Ofwat's assessment of "affordability",
and limited future price increases to around the rate of inflation.
The consequence was to reduce substantially the market values
of the companies to below their regulatory asset bases. Notwithstanding
a degree of out performance on capital and operating costs, the
market values remain subdued, and returns have been low.

4. The current proposed price increases
are caused by:

 the operating and maintenance
costs of the existing networks;

 the enhancement of capital expenditures
to meet environmental and water quality objectives;

 the cost of capital to induce
investors to provide sufficient funds to finance the industry.

These continuing requirements have produced
a sharp rise in prices because:

 there are no longer substantial efficiency
gains;

 the networks require considerable
maintenance and replacement investment which were pruned back
in the last periodic review;

 the cost of capital was set at too
low a level at the last periodic review.

A "roller-coaster" of volatile prices
is to a considerable extent the result of regulatory failures.
The prices set for 2000-05 was unsustainable: customers could
not indefinitely have lower prices and higher investment. Without
the price cuts imposed in 2000, the current projections for 2005-10
could have been financed by roughly constant real prices.

5. The consequence of setting the cost of
capital at a level below that of the cost of equity (but above
the cost of debt) has been to induce a flight from equity.

6. The growth of debt finance and gearing
has had radical consequences. Bank finance brings different incentives,
constraints and managerial focus. Banks are concerned with two
things: getting their money back and getting the interest paid.
They do not have an interest in capital gains, and have limited
ability to absorb shocks. The companies with higher gearing will
tend to be more short-term in focus and less inclined to invest
at the margin. Over time, it will become increasingly apparent
that, as financial ratios deteriorate, future investment will
require rights issues if the continued capital investment programme
is to be financed in the private sector.

7. The flight from equity does not mean,
however, that equity risk has gone away-it has been transferred
to customers and taxpayers. These changes have not generally been
in the long-term interests of customers, the environment or government,
and efforts should be made to preserve equity within the sector.

8. In addition to encouraging returns, which
facilitate rights issues, the regulatory and political risks that
remain within the sector could be further reduced. These risks
arise from the discretion of governments and regulators and the
way it is exercised. Examples include the ways in which the periodic
reviews are determined; the treatment of IDOKs; and the interpretation
of European Directives. Good regulation is typically predictable
regulation. The outcome of the periodic review is far from predictable,
and this uncertainty is reflected in share prices and debt premia.
Ultimately these are costs, which customers will bear.

9. A particular focus of regulatory uncertainty
centres on the IDOK process. The instrument was designed to take
account of unanticipated changes outside the control of management.
There may be rather more items which fall under this description,
and the process itself could be further regularised. With more
predictable elements of cost pass through, the regime could begin
to evolve towards a more flexible and adaptive system, allowing
a more rational approach to investment planning.

10. The periodic-review process truncates
a longer-term investment and management horizon into five-year
discrete periods. This is unfortunate for several reasons. It
creates set-piece artificial decision points, focuses management
on the short term, and encourages game playing. It would be better
to take a longer-term view, comprising an overarching policy framework,
ten-year fundamental reviews, and much more reliance on the IDOK
process to allow flexibility within periods.

11. In the determination of capital expenditure,
the original concept was that the National Rivers Authority (and
now the Environment Agency (EA)) would decide these issues in
consultation and under guidance from the environment department.
During the 1995 and 2000 periodic reviews, Ofwat subverted this
process, taking the leading role, rather than technically implementing
the Agency's decisions. Although there are substantive issues
in relation to the way environmental requirements are evaluated,
and it is important to respond to the willingness and ability
to pay of customers, the roles of the EA and Ofwat have become
confused and opaque. A reassessment of the relative powers, duties
and roles with respect to the water industry is likely to improve
the performance of the regulatory regime.

12. In conclusion:

 a major cause of the proposed sharp
price increases is the significant regulatory failures at the
last periodic review in 2000, and in particular the price cut
then imposed;

 the 2000 price review set a cost
of capital which was below the cost of equity, and induced a significant
flight-from-equity;

 the water sector has, consequentially,
come increasingly under the influence of banks and other debt
holders, with less incentives to invest and less focus on the
longer-term;

 the IDOK process provides a limited
element of flexibility within the regime.

13. It is recommended that:

 the 2005 review process raises the
cost of capital to a level sufficient to reward equity and thereby
facilitate rights issues;

 the IDOK regime is further clarified
and extended;

 a longer-term framework for the sector
is further developed by Defra;

 the five year set piece reviews are
replaced by longer periods, with greater flexibility with periods
through an extended IDOK process.